It’s clear that new venture fundings are still out pacing DeadPool admissions by a large multiple – it looks like $600 million or so was invested in Web 2.0 startups in 2006. And since most startups fail, I expect this commenter may be correct when he says “I predict 2007 will be the year of the deadpool.”

But this doesn’t mean we’re in a bubble. In fact, I think the exact opposite. I think a few failures are direct evidence that we are not in a bubble and that the private venture markets are actually in the process of letting off a little steam to keep things rational.

The Web 1.0 Implosion

Web 1.0 effectively ended on Friday, April 14, 2000, when the Nasdaq lost about 10% of its total value. Between March 10 and April 17, 2000, the Nasdaq lost over 37% of its all time high of 5,133 (and it fell far further later on). The Nasdaq was practically an index of Web 1.0 companies v. the “old economy” NYSE, and it got hammered.

One of the biggest issues driving the collapse was a failure by companies to drive earnings enough to keep up with stock prices. Many public companies had three-digit P/E ratios at the time of the crash. By contrast, the P/E ratios for Google, Yahoo and Microsoft today are 62, 35 and 24, respectively.

The Web 2.0 Reality

Today, the IPO door is nearly shut for Internet companies. GoDaddy withdrew it’s registration statement in August 2005 before going public. NetSuite is next up – we’ll see if they can make it happen in the next couple of fiscal quarters.

There are probably two reasons for the IPO drought. First, there are very difficult reporting requirements now in place that weren’t around in 2000. It takes a lot of administrative overhead to be a public company today. Second, and more important, the public markets have factored in what they learned the last time around and they just won’t let companies go public on the vague promise of future revenues and profitability. Once bitten, twice shy.

That leaves the acquisition market as the only viable source of a liquidity event for most startups. And while there have been a handful of high profile Web 2.0 acquisitions (YouTube, MySpace, etc.), entrepreneurs and venture capitalists have significantly lowered expectations compared to their state of mind in 1998-2000.

Bubble!

But even in this new reality, we’re seeing what looks like way too much money chasing too few good ideas. And when someone does have a good idea, all of the principles of Web 2.0 work to destroy competitive barriers companies try to put in place to protect their business (See Todd Dagres of Spark Capital make this argument recently in the Wall Street Journal).

So when we see a few companies fall, people run for the hills.

But I disagree that Web 2.0 companies cannot become sustainable businesses. The Network Effect is still the most powerful force driving Internet success today. People don’t, for example, go to Digg because it has great software. The original Digg, as launched, cost Kevin Rose less than $2,000 to create. Anyone can create a Digg clone, and many have. The reason Digg is, and will continue to be, successful is because of the community it has created. People go to Digg because everyone else goes to Digg, and every new user who submits stories and/or votes occasionally adds value to the whole network. The Network Effect is also driving Facebook’s success, and YouTube’s. None of these companies have interesting software. All of them have an incredibly valuable community. All of these companies have to work hard to keep their lead, but it is nearly impossible for new entrants to catch up.

And I also disagree that too much money is chasing too few good ideas. We’re seeing a lot of $3 – $8 million Series A round experiments, but not nearly as many follow on offerings. Remember that VC’s business models are designed to fail most of the time – the majority of their investments are expected to go belly up, and they hope that just one or two out of ten have a big return. VCs place a bet, and if it fails they move their money and attention elsewhere. And the entrepreneurs move along to their next thing as well. Assets are allocated efficiently, and everything works out fine in the aggregate.

Letting Off The Steam

2006 may have been a sign that things were getting a little overheated. One long term problem with VCs is that if they get locked out of a hot deal, they fund a competitor. The result is three or four funded startups for every good idea, and they have to fight it out until one hits critical mass and the Network Effect kicks in. This seems to be playing out with the market niche of online slide shows – Slide, FilmLoop, RockYou and Photobucket all have similar products and all are funded. FilmLoop is in trouble, and the other three will continue on fighting.

So there are too many review sites (Yelp, Insider Pages, Riffs, Judy’s Book). And too many Q&A sites (Yahoo Answers, Live.com Q&A, Yedda, Answerbag, Askville, etc.). And too many customizable home pages (Netvibes, Pageflakes, Google, Live.com). And so on. Most of these will fail. Some will win. Hopefully, the total return on investment to the winners will be greater than the sum of all investments in all of the startups. If that ends up being the case, we all win.

As these companies fail, the markets take note. This lets off steam and settles things down. Venture capitalists are less frothy. Fewer investments are made. Valuations go down. Things equalize.

In Web 1.0 companies didn’t fail (until the crash). They just raised more money, at a higher valuation, and gave it another shot. That isn’t happening today. VCs are letting their startups die, as they should. Things aren’t as exciting as they were in 1999, but it’s a whole lot saner.

So every time a startup dies, I don’t think it’s evidence of a bubble about to burst. I think it’s evidence of a market that is working exactly as it should. Most companies fail, but enough win to keep the whole ecosystem healthy.